Leery but not in Denial

Tom Connolly’s Equity Market Forecast
for the upcoming week beginning July 12, 2016
With Market Questions and Answers

Summary Comments:
I walked around this week feeling as though I was missing something. I was struggling, and continue to struggle, with the justification for the advance in the market from a valuation perspective, while recognizing that I cannot ignore the breadth and depth of the participation that is the backbone of the advance. This is a market that simply wants to go higher whether that advance is logical or not.

I remember feeling this way as we came out of the 2008 financial crisis. The valuation metrics in 2009 and 2010 were not supportive of the advance at that time, an advance which was being driven by an oversold market and the monetary support from the FED through Quantitative Easing. I keep thinking that, similar to 2009 and 2010, the forecasts for cash flow growth must be incorrectly low and that the market is recognizing future strength that the analysts are missing. I must admit that I presently do not see where this future accelerated growth is to come from, given the current 2017 forecasts for cash flow growth are already at 12.41% over the forecasted 2016 cash flows. With that growth assumed to be in the bank, the current market is trading at 16.77X of the 2017 cash flows. A very fully valued multiple.

If it is not unanticipated cash flow growth that is driving the market advance, should the foundation be in the yield spreads between fixed income and equity earning yields? To test this hypothesis, consider the spread of the earning yield of the S&P 500 over the ten-year Treasury yield. It presently sits at 2.70%. Over the past year it has ranged from a low of 2.20% to a high of 3.12%. The current differential is right in the middle of the pack, so absent continued declines in bond yields, the current earning yield on equities is not, based on recent history, a powerful driver in support of equity purchases, particularly given the capital risk of equity price declines. The yield spread does support the equity pricing we have, but this further assumes Treasury pricing is rational with the Ten Year at 1.36%. I wonder about that given the small differential between 3-month money and ten-year money which is approximately 1%. Risk-Reward just feels completely out of touch with reality.

Be careful out there.

Prior week’s investing activity: A focus on extending the short side hedges to protect the equity gains was paramount. The strength of the market move higher is pushing valuation boundaries and as such the increase in short positions seemed appropriate. The net impact of the shorts was to shave the YTD gains on the overall Connolly portfolio. The extended gains with the Gold and Silver miners was welcome, but I sold into some of the strength to reduce the overall PM position. I was, and remain, very leery of the market at its present levels, but cannot deny the upward momentum that is present.

My portfolio’s YTD performance vs the market, and its current composition as of July 8, 2016, are as follows:

Connolly Portfolio YTD gain as of July 8, 2016 equals + 9.85%
S&P 500 Index YTD gain as of July 8, 2016 equals + 4.21%
NASDAQ Index YTD loss as of July 8, 2016 equals – 1.01%

The Portfolio’s composition as of July 8, 2016 is as follows:
• Cash 42.3%
• Equities 39.1%
• Gold 15.4%
• Fixed Income 3.2%

Forecast for the coming week: U.S. equity market momentum is carrying the market higher. The news releases for this week are notable from a consumer and inflation perspective. Given the employment strength from last week and the muted market reaction to BREXIT, a refocus on a FED Rate increase may emerge in the traders’ dialogue. Expect the week to begin with strength and follow-thru, but an early upward move may very well fade into the latter part of the week.

Market Questions and Answers

What are DJIA, DJT, DJU, S&P and NASDAQ metrics indicating?

The upward pressure on what had been ceilings is beginning to press through resistance points on the individual charts of the major equity indexes. I am surprised by this strength. The S&P and DJIA are at that point where any closing week gains will give support to the view that we are out-of-the-woods in terms of a downward channel governing future market behavior. The NASDAQ is also looking to break a mid-level point of resistance and should be watched for additional gains.

Relative Strength: The level of up and down points in the RS index are more or less offsetting. The roll-off of prior week down action will bring the RS indicator into overbought territory in the coming four weeks, so a technical correction down between now and the end of August is in the cards, but the near-term strength is the dominant play at the moment.

Price Earnings multiples are 24.62X for the S&P 500 and 19.40X for the DJIA, indicating an expensive market to invest in at these levels.

The DJT rose nicely but remains in a declining chart pattern. It has been a leading indicator of the broader market. The continued selling of the Transports is a strong negative for the overall market.

The DJU has moved to a new high as investors seek yield reflecting the cautionary investing strategy of a market that poses greater risk then reward for investing in growth oriented businesses. Safety is being sought.

What is the current score on the “Market Tells metric”?

The Market Tell indicator, which is a comparison of the market’s current cash flow and valuation metrics to its historic medians, closed the week at negative 132. As an FYI, when we have a high positive reading this is a strong buy signal and when we have a high negative reading it is a strong sell signal. The -132 reading indicates an expensive market. The highest negative reading here was -182 on November 6, 2015. The strongest positive reading was +28.5 on February 12, 2016. Last year at this time (July 10, 2015) the reading was -112, which foretold the summer of 2015 declines in equity prices. We are at a similar place with declining cash flow estimates for the year occurring when high current multiples characterize the market.

The Portfolio’s Cash flow multiple based on expected 2016 full year results is 18.86X. This is a relatively high reading of price to cash flow when compared to the historic median of 16.96X. This is getting closer to an extreme overvalued market (19.72X was last extreme point before a sell-off). The expectation of earnings and cash flows are falling in a market that desperately needs improving operating performance to justify its current value. This does not bode well for equity price appreciation from this point forward.

Comparing current equity prices as the week closed on the 187 portfolio companies to their Discounted Cash Flow values indicates 72 companies were priced above their DCF value which exceeds the historic average of 61 for the portfolio. This supports an expected fall in the market as more companies have become overvalued and need to correct lower.

The dollar spread between the Current Price and the Discounted Cash Flow price utilizing 2017 cash flow projections on the 187 Portfolio Companies is now at $16.55. The difference or spread today is below the historic median of $22.38. A higher spread indicates greater value to invest in whereas a lower spread indicates subpar returns will be realized from investing at current prices. In this environment it should be apparent that future performance has been pulled into the current pricing in a manner that reduces potential gains absent a significant improvement in future earnings and cash flows.

What is the position of the weekly net up down Vol/Issues?

The week’s volume and issues were perfectly aligned with the market move higher. Strength in volume on the buy-side and the overall participation as reflected in the number of issues advancing confirmed the strength of the move higher.

What are the daily point vs issues and point vs volume measures indicating up or down?

The daily metrics of (1) index point moves being supported by the daily advancing or declining volume, and (2) the index point moves being supported by the daily rising and falling number of issues traded, confirmed the support for the market.

Where are the New Highs and Lows moving toward?

We are seeing a meaningful rise in the number of companies hitting new 52 weeks highs. The broadening of the issues that are advancing is a positive as leadership is no longer from just a few.

How well are Market Tells correlating with Market trading internals?

The technical market indicators and the Market Tells of valuation are not in alignment. This is an indication that future volatility will arise to bring about a resolution of this imbalance. As we continue to extend gains the level of risk for a dramatic decline to adjust the price of the market to the cash returns from the market becomes increasingly dangerous. Close attention needs to be paid to exogenous events that could ignite a market reversal of current buy-the-dip psychology.

What is the composite reading of the Calendar, Environment, Duration, Action, Trend, Emotion and Valuation Index (“CEDATEV”)?

The reading is 0 (zero). This score reveals a market that has many competing influences. The world events and economic trends coupled with an expensively priced group of stocks and bonds is dancing on emotion that reflects the climb over a wall of worry. I see great risk in this combination.

Contributors are:

Negative in the following areas:
Environment
Valuation

Positive in the following areas:
Action
Trend

Neutral in the following areas:
Calendar
Duration
Emotion

Other:

Bitcoin fell this week to $645 per coin. The continued volatile movement in this digital currency is telling us something important. I believe it is the economic and political turbulence in world markets that is creating buying and selling here, and it reflects a foreshadowing of greater uncertainty and loss of confidence in the Central Banks of the world. Something is happening in the alternative currency sphere that should not be ignored in terms of the implications for the broader financial markets. The per unit value based in the low $400 area over the past four months. Over the past year, the price has increased by over 200% from the $230 area. I hold a position in Bitcoin as we move closer to digital currencies vs paper money and coinage. Please note I also own stock in the company PayPal (symbol “PYPL”) and Square (”SQ”) given the success and reach of digital online payment platforms.

The Dollar Index has been firming and now sits at 96.27. Over the past twelve months it has traded between 93 and 100. The dollar has appeared to be range-bound in this area. The latest global economic data failed to indicate economic improvement in the United States and in other geographies throughout the world. We should see the US Dollar act as a safe haven.

Gold closed the week at the $1,367 per ounce. The global phenomena of negative interest rates on sovereign debt in many parts of the world are giving support to the price of Gold. In the past week, the Gold and Silver Miner equities rose meaningfully. I believe there is much more room to the upside for these equity holdings. Given the continued global uncertainty and currency volatility issues that exist, I do see material price increases for gold and silver in the foreseeable future and for Gold to advance much higher above the $1,300 level. I will therefore maintain my PM positions (with modest sized exits and entrances to capture periodic swings above or below a normalized trend) to offset potential equity price declines from the broader market.

The Ten-year bond yield dropped dramatically and closed at 1.36%. We are now at yields that seem irrational given risk reward profiles of return. The economic signals I see from the latest government releases show an economy that is contracting. The behavior of the Bond market is confirming that economic slowness. Of concern is a flattening of the yield curve (recession) and the absence of economic activity that a steeper yield curve, if we had one, would indicate. Again, the safety trade of the US is a dominant theme, and yields may fall further as the safety and liquidity of the U.S. market is sought.

Commodities: This week we saw the CRB commodities index decline. The softness in economic demand factors and the rise in the value of the U.S. Dollar are negatives for the pricing of Oil and the Industrial commodities.

The High Yield vs Investment Grade spread contracted to reach prior support and is an indication of a perceived low level of risk in the high yield market. This is also supporting the rising equity market and the risk-on trade. We closed this week at a spread of 3.897% and the indication was to take risk-on. Over the past two weeks the range has been 3.94% to 4.352%, and we are now reaching a new low. High Yield is at 6.513% and Investment Grade is at 2.616%. If the oil market fails to hold the price of a barrel near the $50 mark or higher, the health of high yield market may once again show pressure. A fall in oil will be problematic for the High Yield market and a general negative for the overall market.

That about covers it for this week.

As always, have a great week!

Tom

Author: Thomas Connolly

Tom possesses a rich and diverse background that includes deep investing experience, senior corporate executive positions, and roles as a Regional Managing Partner and Global Industry Leader within Ernst & Young. He has advised executives on some of the largest acquisitions and dispositions in the Media and Entertainment industry, including clients such as Comcast, Citibank, Sony, Dalian Wanda and Publicis. Tom is a Certified Public Accountant with a Masters Degree from Columbia University. His skills are further accompanied by a personal passion for the study of economic trends and evolving market dynamics.

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